Wednesday, June 22, 2005

The expansion will raise daily gasoline output by 11,900 barrels, or 500,000 gallons, to about 131,000 barrels, [Steve Renfroe, Chevron Spokesperson] said. The $150 million project is expected to begin in July and be finished in late 2006.

I don't doubt that additional refining capacity will be needed. But the following sentence in the article perpetuates the myth that the lack of refining capacity is contributing to the high price of oil:

The shortage of refining capacity worldwide has contributed to the 57 percent rise in oil prices in the past year.

This is similar to a recent comment by Saudi oil minister Ali al-Naimi:

"There is no shortage of oil. It's there. What is driving the price is the inability to make the oil into products."

The BBC article continues:

Some analysts say there are insufficient oil refineries, both in the US, where no new refineries have been built since 1976, and worldwide.

This shortage could help keep oil prices high.

Here is a simple diagram of a bottleneck:

Raw Material --->> bottleneck --->> Finished Good

What happens with a bottleneck? If the process is running at full capacity, there is a fixed supply of finished goods, so the price of the Finished Good will rise rapidly with any increase in demand.

But what happens to the price of the raw material? Since the process is running at full capacity (a bottleneck), the demand is fixed, and any additional supply of raw material will cause the price of the raw material to drop!

For the Oil industry: Crude oil is the raw material, the potential bottleneck is the refining process and the finished good is gasoline (also other products, but I'll use gasoline in this example). If refining is at or near full capacity, any additional demand for gasoline would increase the price of the finished good (gasoline) but would not change the demand for crude oil (demand is fixed by the refining bottleneck).

Since demand for crude would be fixed with a bottleneck, any additional supply of crude would depress the price of the raw material (crude oil). Therefore the lack of refining capacity could only depress the price of crude and would not contribute to the rise in the price of crude - the opposite of what is being reported. Adding more refining capacity would increase the demand for crude oil and could lead to higher crude oil prices, unless additional supply of crude is brought online.

Perhaps the Saudi oil minister has ulterior motives for blaming refining for the high price of crude oil, but that doesn't mean the financial press should perpetuate the myth.UPDATE: In the comments, darffot suggests that he interprets al-Naimi's comments as: The lack of refining capacity for sour crude is pushing up the price of sweet crude. Here is darffot's comment:

i would like to offer an alternative interpretation, which is the way i have always taken al-Naimi's comments on this issue: the incremental production adds coming out of SA and elsewhere is primarily high-sulfur "sour" oil. this is oil which most refineries cannot process, especially thanks to recent enactment of emissions legislation in various parts of the world. just as American electricity producers created a glut of NG-based power plants in keeping with the clean air theme, refinery capacity additions have been skewed toward light sweet oil, which is easier to process with lower pollutants. and, just like the NG-turbine additions, these geniuses did not stop to think beforehand whether the supply would be there when the capacity came on. the result today is that there is high competition for light sweet crude (the widely followed WTI) while the excess sour production goes begging for buyers. this can be clearly seen in the historically large spreads between sweet and sour crude products, and is also very apparent in the chart of Valero (VLO), the US based refiner most heavily focused on sour crude. just listen to a VLO conference call and you will learn how they are printing money thanks to the record spreads between sweet and sour. this, i believe, is what al-Naimi is alluding to when he says there is not enough refining capacity--there's not enough sour refining capacity to keep in alignment with the composition of crude coming online at the margin. meanwhile, there is high competition for the sweet crude.

UPDATE 2: According to a recent Forbes article, the spread between light and sour has increased from $2.50/ bbl to almost $9/bbl over the last 2 years. This is darffot's point and he is clearly correct about more demand for light sweet crude.

However, this still means there has been a substantial price increase for sour crude (from around $27 to almost $50 today spot prices). Perhaps a few dollars of the WTI prices are related to refinery mix (but that isn't what the financial press claimed), but blaming the doubling of oil prices on lack of sour crude refining capacity is also incorrect.

In Memoriam: Doris "Tanta" Dungey

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